After a period of negative market sentiment about synthetic replication caused by the bankruptcy of Lehman Brothers, which was the starting point of the financial crisis in 2008, investors seem to have returned to this replication method. As a consequence, we see a higher launching activity of the ETF promoter in Europe when it comes to these kind of ETFs.
Generally speaking, there are two ways how an ETF can replicate its underlying index. The first is the so-called physical replication, where the ETF holds the actual securities in its portfolio. The second is the so-called synthetic replication where the ETF normally holds a total return swap and a set of in-kind securities as collateral. Both replication methods have their strengths and weaknesses which will be unveiled in this article.
ETFs that use physical replication can do so in two different ways:
Full Replication: The ETF holds all securities of the underlying index in the exact proportions as the index.
Sampling (or Partial Replication): The ETF holds a representative sample of the securities in the index with the aim to replicate the risk/return profile of the index as close as possible by using the lowest possible number of securities.
While full replication is used for indices with a smaller number of highly liquid securities, sampling is used for indices with a high number of securities and/or indices which contain securities with a limit liquidity.
Conversely, ETFs that use synthetic replication normally hold a total return swap based on the respective index and a portfolio of in-kind securities as collateral for the swap. In-kind securities are securities from the same asset type as the underlying index, but they don’t have to be index constituents at all. Most ETFs hold a portfolio of very liquid securities as collateral for the swap. In some cases, futures or other derivative contracts are used for the replication of the risk-/return-profile of the index instead of a total return swap.
In addition to this, there are also some ETFs that can use one or the other, and in rare cases, even a mix of replication techniques to achieve their goals as per their fund prospectus.
In some cases, ETFs are launched as synthetic ETFs, which are supposed to be converted into full replication ETFs once they hold enough assets under management to buy a sufficient number of the underlying securities. This use case underpins the efficiency of total return swaps for modern portfolio management techniques.
Advantages:
ETFs using full replication are easy to understand since they are highly transparent and are very simple products since they hold the securities of the index with the same weightings as the index. Conversely, ETFs using sampling as replication method are partly losing this advantage since the portfolio is made from a sample of securities which may not match the securities and/or their weightings in the respective index.
Since ETFs using physical replication directly own the securities in their portfolio, they are able to implement securities lending as an additional income source. The possible income from this modern portfolio management technique can lower the total expense ratio of the respective ETF.
On the other side, ETFs using synthetic replication may have a low tracking error since the performance of the swap should replicate the risk-/return-profile of the index very accurately.
Synthetic ETFs should also be more cost efficient as ETFs using physical replication since there are no transaction costs for the ETF when the index is rebalanced.
In addition, synthetic ETFs can provide investors with access to asset classes which can’t be accessed with physical replication such as (soft) commodities or some more exotic securities markets with a lower overall liquidity.
Disadvantages:
While the low transaction costs for the ETF are seen as an advantage for synthetic ETFs, these costs are a disadvantage for ETFs using physical replication. In addition, the tracking error for ETFs using physical replication, especially for those using sampling, can be significantly higher than for synthetic ETFs.
The high transparency and simplicity are a clear advantage for ETFs using physical replication, while the complexity of derivatives within their portfolio is seen as a disadvantage for synthetic ETFs. That said, ETFs which are using securities lending do have the same issues since the securities lending program adds another level of complexity.
When it comes to this, the counterparty risk from the swap contract is often seen as a disadvantage for synthetic ETFs, but investors need to be aware that ETFs using physical replication often utilize securities lending programs to enhance the returns of the portfolio, which bear the same kind of risk.
It can be concluded that all common replication techniques used by ETFs are suitable for replicating the respective indices as accurately as possible. Nevertheless, it should be noted that all replication techniques have their pros and cons, and it is the duty of the investor to choose the replication methodology which suits his expectations and needs best.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
